Tuesday, August 21, 2007

I come to bury the Housing Boom, not to praise it.

OK, I lied: I come to praise it. Basic macroeconomics is leading me to some unpopular conclusions:

The housing boom was a good thing; therefore

Far from worrying about moral hazard, the Fed should be deliberately rewarding those who participated; and

(At least according to my reading of the macroeconomy) The Fed should encourage the continuation of a housing boom (or something of that nature).

My basic argument is quite simple: without the housing boom, there would have been no economic recovery, and…recovery is good.

It’s not very controversial that the housing boom was the main reason for the economic recovery, so let’s do a thought experiment in which we re-run the years since 2001 without a housing boom. Would something else have happened instead to produce a recovery? Let’s line up the candidates.

First, fiscal policy. We did have a war, two large tax cuts, and a large new entitlement benefiting the age group with the highest marginal propensity to spend. The consensus is that all these were not enough. Perhaps they would have prevented the recession from getting worse, but without the direct and indirect effects of the housing boom, any recovery would have been meager at best. OK, how about a big public works program? Not a bad idea, if you ask me, but this is where we have to begin distinguishing between thought experiment and fantasy. If your conception has a public works program that dwarfs the New Deal being passed by a Republican Congress and signed by George W. Bush, I recommend you get in touch with George Lucas about the special effects.

What about an export boom (and/or substitution of domestic products for imports) supported by a weak dollar? That is, after all, the traditional mechanism by which monetary policy is supposed to operate in an open economy with a flexible exchange rate. The first problem that arises is that the US exchange rate against many countries isn’t (and, most emphatically, wasn’t) flexible, and even when it is nominally flexible, the competing products are often effectively priced in dollars. One could imagine a mildly successful beggar-thy-neighbor policy against Europe (supposing that, in the absence of a housing boom, the dollar would have crashed against the Euro in 2002 instead of falling gradually over 5 years). At best, that gives us a mild (and somewhat stagflationary) recovery in the US and a severe recession in Europe (which, as you may recall, had its own problems in the early years of this decade). All in all, the possibilities created by a falling dollar (in place of the housing boom) are not impressive.

So what’s left? An investment boom supported by low interest rates? If it didn’t happen when the federal funds rate was at 1%, would it have happened if the rate had fallen to 0%? I tend to doubt it. An investment boom supported by “quantitative easing”? Possibly, but it took Japan years even to hit on that possibility, and the jury is still out on whether quantitative easing was the real reason for Japan’s recovery. The premise that such a policy would have been tried successfully in the US during this decade is speculative at best. Other ideas? Money dropping from the sky? Maybe, but remember, “Helicopter Ben” didn’t take over the Fed until 2006. And so on….Rather than going from the bizarre to the more bizarre, I’m just going to reassert my premise and suggest that the burden of proof is now on anyone who disagrees: Without the housing boom, there would have been no economic recovery.

The implication of having no economic recovery is that we would have slack resources the whole time – the sort of event that used to be called a depression before the term fell victim to political correctness. Thus, comparing my counterfactual world to the actual world, all the extra production that we got out of the US economy was done with resources that would otherwise have been wasted. From a macroeconomic point of view, all those extra houses and such were free – a free lunch, if you will. (I won’t abide any more TANSTAAFL: in Keynesian economics there has always been a free lunch; that was the main point of the General Theory.) So those who say that the housing boom was a bad thing are saying that we should have turned down that free lunch when it was offered.

And what of those who participated in the boom? To my mind, they are in the same category as the Iraqi Shiite rebels in 1991. They helped US policymakers accomplish their laudable goals. (I won’t apologize for being a supporter of both Desert Storm and this decade’s economic recovery.) Sir Alan even flew a mission over their region to drop leaflets touting the virtues of ARMs. And now should we leave them to be massacred? I’m not saying we should invade the mortgage derivatives market and set up a democratic regime by force. But at the very least, don’t we have a humanitarian moral duty to declare a no fly zone?

This post is already too long, and I have to get back to my real job. I haven’t even finished arguing my second point, and the third point is clearly going to be the hardest to defend. For now I’m going to have to abort, hoping to continue tomorrow. Have patience, gentle friends….

But Dean Baker says the Housing Boom was an obvious bubble:And Dean Baker is an honorable man; So are they all, all honorable men*…

* Yeah, OK, some of them are honorable women, I guess. Sorry, but the ART is doing Julius Caesar this season, and Shakespeare's lines already glide silently but pervasively through the New England air.

18 Comments:

Transferring from one bubble (tech stocks) to another (housing) at least had the value of being relatively more egalitarian. I'll give you that.

But, as any diver can tell you, Bubbles are Dangerous, and the way to get rid of them is a SLOW ascension, exhaling upward as you return to normal pressure.

Run your scenario ca. late 2003--the economy is recovering because of that initial depth and the bubble aspect is clear; now it's time to return to the surface or risk a too-rapid ascent. (Speaking as one who lost his weight belt at 60', I can vouch that a rapid ascent is NOT a good feeling.)

If you're still dependent on housing expansion, then your alleged recovery isn't broad-based (which was, to be fair, your initial point) and you need to look very carefully at things such as that 2003 piling on and whether the crowding-out of running two privatized wars is suppressing entrepreneurial efforts. And you have a chance to avoid the current decompression tanks.

Is a bubble-based recovery bad? Not definitionally; recovery is recovery. But expansion is another question, and it's fairly clear that the housing bubble didn't produce an expansionary effects (save possibly in Investment Banking employment, where stuffing your pension fund with securitizations of those negative-amortization ARMs became an art form).

Have you read:http://www.federalreserve.gov/pubs/feds/2007/200737/200737pap.pdf

The argument is that one of the consequences of the boom and its attendant financial innovations is that households with poor financial characteristics have had a disproportionately large effect on the macroeconomy, preventing the recovery from being more of, well, a real recovery.

Japan had its investment and housing bubbles concurrently. It was followed by an extended period of semi-depression.

The US had its investment and housing bubbles serially. If they are both facing the same long run structural problems maybe this implies that having the bubbles sequentially is better than having them concurrently.

Like Japan, we are now faced with what will be the growth locomotive in the next cycle. But maybe because our investment bust is now behind us the US will be able to adjust better.